'Sharp' Chinese downturn on the cards

Investors should be cautious of the perceived strength in China’s economy as further monetary tightening could trigger an unexpected downturn, says Standard Life Investments.

In a note to investors, Standard Life Investments emerging markets economist Alex Wolf said sentiment on China had recently rebounded owing to “stabilising growth”, but that markets may be overreacting to “China’s perceived strength”.

“Looking back at 2015, Chinese growth substantially deviated from potential growth primarily due to policy errors,” he said.

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“Ignoring the stability of the official GDP series, it’s clear based on raw production data, industrial data such as electricity consumption or even retail data that growth weakened substantially.”

Mr Wolf said local-level debt creation had been stifled by “well-meaning” fiscal policies and that anti-corruption measures had “exacerbated the local spending freeze by inducing policy paralysis”.

“The stabilisation we are now seeing is broadly due to the reversal of these policies: local governments have been allowed to sharply increase debt, the anti-corruption campaign has been eased at the local level and capital controls were reinforced,” he said.

“What lessons should we learn from this? First, that Chinese growth is now largely back in line with potential growth given its level of development (5 per cent); but second, any reform that removes policy support could spark an unexpected slowdown.”

Mr Wolf noted that the People’s Bank of China (PBOC) is working to contain rapid credit growth by “raising rates in monetary tools and withdrawing liquidity on a net basis while simultaneously rolling out stricter Macro Prudential Assessment”, but cautions that China has a “track record” of triggering sharp downturns through well-meaning policy efforts.

“Additionally, as most of the tools in the PBOC’s arsenal are relatively new, and fragmentation of the financial sector occurred rapidly over the past few years, the impact of tightening interbank rates on regional banks is relatively unknown,” he said.